To give you a feel for the book 'Why Economic Depressions happen - we're heading for one', here are a few selected extracts from the start of William's book:
FORWARD
Most people, including most economists and politicians, didn’t see the 1930s depression coming and most people didn’t see the current depression, which we are sliding into, coming. The key questions are:
What danger signs were they missing?
Where did we go wrong?
What are our options?
What do governments need to do to get back on track?
What should businesses, individuals and families be doing?
PART ONE – ECONOMIC ISSUES
CHAPTER 2 DEPRESSIONS
2.1 Description of a depression
In Wikipedia there is a summary of the 1930s economic depression:
“The Great Depression had devastating effects in virtually every country, rich and poor. Personal income, tax revenue, profits and prices dropped, while international trade plunged by more than 50%. Unemployment in the U.S. rose to 25%, and in some countries rose as high as 33%. Cities all around the world were hit hard, especially those dependent on heavy industry. Construction was virtually halted in many countries. Farming and rural areas suffered as crop prices fell by approximately 60%. Facing plummeting demand with few alternate sources of jobs, areas dependent on primary sector industries such as cash cropping, mining and logging suffered the most. Some economies started to recover by the mid-1930s; in many countries the negative effects of the Great Depression lasted until the start of World War II”
A summary of the effects of a depression include:
it is hard to sell goods and services
prices for most things drop
many businesses close,
a large proportion of jobs are lost,
the collective income of workers and business owners drop dramatically,
overall wealth is decimated
PART TWO - What went wrong with our economy: RESILIENCE + RISK
CHAPTER 3 My theory part I:
RESILIENCE + RISK BOTH WENT THE WRONG WAY
The main reason our economy is in the current mess is that these two key measures both went the wrong way:
Resilience went down massively, and,
Risk went up massively.
Resilience is the ability to withstand something going wrong and our collective economic resilience has become very low. At the same time the collective risks being taken by those in our economy have increased the chances of something going wrong. The combination has left us in the position that things are going wrong and we don’t have the resilience to withstand the consequences.
3.1 Money equals financial resilience
In our society money enables people to buy virtually any goods and services. Thus as a general rule, money is equivalent to resilience. The more money someone has, the more resilient the person is. Similarly, the more income someone has, the more resilient the person is, provided the income doesn’t stop.
3.2 Factors affecting resilience and risk for an ‘individual person’
Some normal things that effect resilience and risk for a person are:
1. Employment increases resilience. By having a regular paid job, a person can hopefully pay living expenses and also save some money.
2. Savings (and investments) generally increase resilience. By saving money a person has money to buy food and meet expenses when something goes wrong, or, for retirement. Hopefully the savings will also be generating some income too. The higher the savings, the greater the resilience.
3. Owning ‘a home’ generally increases resilience because rent doesn’t have to be paid and even if income drops, the homeowner doesn’t have to find rent.
4. Debt reduces resilience because the debt has to be repaid plus interest has to be paid.
Please note that in borrowing to buy a home, it is possible for the reduction in resilience from going into debt to be outweighed in the long term by the increased resilience of owning a home.
Similarly, when someone borrows money to start a business they are taking a risk that they hope will lead to greater resilience down the track.
Also note that debt increases risk because if a job is lost or something else goes wrong then the loan may not be able to be repaid, which may lead to losing the home or business.
5. Insurance can reduce risk and increase resilience. For example there are insurance policies that protect against job loss, fire, accident, injury, etc There is almost always a premium cost for insurance.
6. Going guarantor on a loan for someone generally increases risk for the person doing ‘the guaranteeing’
7. Lending money to people who may not be able to pay it back has the same effect.
8. Spending more than a person earns is generally bad for resilience. Conversely, spending less than a person earns is generally good for resilience.
9. Gambling increases risk, and, losing with gambling reduces resilience,
10. ‘Investing’ in speculative assets is generally like gambling although most people don’t see it this way at the time. Using borrowed money to ‘invest’ in speculative assets increases the risks even more.
11. Running up unfunded liabilities is also not good for resilience. For example not saving for retirement means that the person will be reliant on government once their working life has finished.
12. Selling assets and spending the proceeds reduces resilience. Another example is borrowing against the value of an asset (eg a house) and spending the proceeds.
13. Not maintaining assets (such as a house), so the asset value drops, also reduces resilience.
For most people this is common sense and these are prudent guidelines to manage their finances.
3.3 A ‘personal depression’
A ‘personal depression’ can occur when something goes wrong for an individual. It can happen with:
losing a job and not being able to find another one,
lending money to someone and not getting it back, or
any combination of unfortunate events that usually include something from the negative personal resilience and risk factors listed above.
3.4 Other observations on resilience and risk
Some other observations on resilience and risk include the following:
3.4.1 Resilience is very difficult to build up, and very easy to destroy
Someone can lose their entire life savings by ‘investing’ in a venture that fails or with a gambling addiction. It is very hard to rebuild this cash for most of us. In summary, it is easy to spend money and hard to save it. It also takes a long time to save a significant amount of money.
3.4.2 Resilience can disappear unexpectedly, often unseen
Sometimes resilience can disappear very quickly, or, have been gone for some time and we haven’t realised it. For example we discover that our house is infested with termites that have destroyed the timber framing and we have no insurance to cover it. Until the discovery we thought we had a house however for some time before the discovery we have had a block of land with a worthless shell of a house on it. Another example may be that our life savings consisted entirely of Enron stock (shares). When the company went broke we found we had nothing.
Inflation also eats away at resilience, usually unseen, and we get to this later.
3.4.3 Risk is very easy to take and can often be taken inadvertently
This is closely related to the observation above on losing resilience. For example if I place my life savings in a bank and the bank goes broke (bankrupt) then I may be left with nothing unless the government decides to compensate me.
Chapter 4 My theory part II:
MASSIVE RISK TAKING GENERALLY RESULTS IN THIRD PARTY HARM
(“Third party” means other people, usually not related to the person causing the problem)
The second reason we’re in a mess is that massive risks have been taken, that are likely to result in harm to many people who are often far removed from the people who took the risks.
4.1 Low risk leads only to self harm
If I start a business and use my own money then if the business fails and I pay all the debts it is only me who will suffer the loss. I have taken a small risk.
4.2 Large risk taking leads to harming of others
Assume I take a large risk and start a business with almost no money of my own, and use money borrowed from friends, then, if the business fails they will suffer the financial loss. If a relative went guarantor on additional bank loans then the hapless relative will probably lose money too. Suppliers will generally not be paid and neither will the bank if the guarantee isn’t enough to cover the borrowings etc.
Another example could be where I have a gambling problem and I borrow money to fund my ‘lifestyle and gambling.’ When I run out of credit, I will have spent other people’s money and they won’t be getting it back.
4.3 Low resilience leads to a ‘domino effect’ with financial harm
Where resilience is very low across the board, there is a high probability of a ‘domino effect’ that ‘takes out’ people (financially) who are even further removed from the original risk takers.
For example a company ‘A’ with low resilience takes a risk and goes broke. Company B also with low resilience has been supplying goods on credit to Company A. The loss for Company B of not being paid by company A is enough to push Company B over the edge, etc. In each case there are others harmed, including people who lose their jobs and people who don’t get paid money they are owed.
The same principle applies with large risks. A large risk can take out a lot of people and a gigantic risk can have a massive domino effect.
Financial harm always further reduces the resilience of people who lose money.
4.4 Results of Domino effect
There are three levels of severity of economic harm:
4.4.1 Recession
In a recession resilience is very low across the board and high risks cause a significant domino effect with many people suffering financial harm.
4.4.2 Depression
In a depression the domino effect is even greater because of greater risk and lower resilience. Most people suffer.
4.4.3 Total Economic collapse
Total economic collapse would occur when all people suffer catastrophic financial harm.
As you can see, a depression isn’t our biggest potential problem. On the positive side, we can still do things to minimise the harm done and preserve some of our economy. We’ll get to the positive things later.
[The chapters continue with more parts of the theory and brings the whole theory together]
PART THREE - THINGS THAT HAPPENED RESULTING IN RESILIENCE + RISK ISSUES
Many governments, banks, businesses and individuals have done significant things that have resulted in our collective resilience and risk issues. Most people have not been able to see the danger building up.
Let’s look at some of the main things that happened in our economy and look at how they affected the resilience of, and risk to, our economy.
CHAPTER 7 Banks have massive derivative exposure
I have listed this as the first issue because the potential risk is so large that even a small hiccup could wipe out our entire economy. First we need to understand what derivatives are:
7.1 Derivatives
7.1.1 Derivatives explained
Derivatives are a way of betting on which way market prices will go. For example if I believe that the price of oil is going to go up substantially I can make a bet that will pay me a profit if the price of oil goes up by a certain time. For this bet to take place there needs to be someone who believes the price of oil is going to go down in the same timeframe who wants to bet ‘the opposite way.’
By betting on the price of oil I can potentially make a profit without the hassle of buying oil, finding somewhere to store the oil, paying for transport of the oil, paying for insurance for the oil and paying for storage etc.
7.1.2 Derivatives for vast range of ‘underlying assets’ (whatever the market is betting on)
Derivative markets exist for most commodities including oil, gold, wheat, etc as well as for intangible underlying assets such as interest rates, exchange rates, share prices etc.
7.1.3 Leverage magnifies the result
The main reason people use derivatives is that it allows for large leverage. Leverage means that a small outlay can result in a very large profit if the bet wins, and very large loss if the bet loses. For people who think they know ‘what future prices will be,’ this is seen as a benefit. Using the oil example, I don’t need to pay for the quantity of oil I’m betting on; I just need to pay a small deposit.
7.1.4 Counterparties
The person betting against me is called my counterparty, and, I’m his counterparty. Every winner needs their counterparty to be able to pay their debts.
7.1.5 Derivatives can be good insurance
An oil refiner buys oil on an ongoing basis. Assume that he is worried the price of oil is going to go up in the near future. He can use derivatives to buy the equivalent of his future oil needs that will effectively lock in some of his future oil needs at today’s prices. This insurance is called ‘hedging.’ Note that if the price of oil goes down then he will not get the benefit of any price fall in the same way as he will not have to pay any price rise. His price gets locked in.
7.1.6 Most derivatives are gambling
Bets that aren’t hedging are speculation which is gambling. The bulk of the value of derivative bets are now gambling.
7.1.7 Outstanding exposure
It is estimated that the outstanding exposure of bets is well over $700 Trillion dollars worldwide. This is an astronomical figure which we get to shortly. Unfortunately the derivative markets are so large compared with the underlying asset markets, and, the players so powerful that they often determine the prices in the underlying assets. The bulk of this worldwide exposure is on interest rates and exchange rates which is where banks come into the picture.
7.2 The banks and derivative exposure
Most people are blissfully unaware that banks around the world, including Australian banks, have been running up risk on a massive scale in derivative markets. What’s worse is that government regulators have allowed banks to keep this gigantic risk out of banks’ balance sheets. A balance sheet is meant to be a snapshot of a whole business with all the good and bad things shown together. By allowing banks to leave these risks outside the balance sheet, even many informed financial people are not aware of the problem or its scale.
We know how big the risk is collectively for the Australian Banks because the Reserve Bank of Australia does a summary spread sheet that is updated quarterly.
7.3 The scale of the problem in Australia
Australian Banks have a combined exposure of over AUD$23,000 Billion (or AUD$23 Trillion) to derivatives and other “off balance sheet business” as at 30 June 2013. These are the most recent figures publicly available at the time of writing.
To verify these figures:
Go to the Reserve Bank of Australia web site www.rba.gov.au
Select Statistics (next to the Search box)
Then from the In Statistics menu on the left side of the screen select Economic and Financial Statistics
Next choose Statistical Tables
Open the Excel spreadsheet B2 – “Banks Off Balance Sheet business”
The figure you’re after is the last figure on the page
The source is credited to APRA (Australian Prudential Regulatory Agency)
This is their exposure, not their turnover.
(If these instructions don’t work it will be because the RBA sometimes changes things. If this happens, please see my web site, detailed in the last chapter of this book for updated instructions)
To get this $23T figure into perspective the total shareholder equity (value of the banks owned by shareholders) of the banks at the same date was a mere AUD$200 Billion (or AUD$0.2 Trillion). Thus, the total shareholder equity in our banks is less than 1% of the banks’ combined “off balance sheet” exposure.
Some other figures may help in getting $23 Trillion of exposure in perspective:
The Australian Federal government budget is less than AUD$0.4 Trillion per year
the whole Australian economy produces about AUD$1.3 Trillion per year,
the whole US economy produces about US$14 Trillion per year.
As you can see, the figure of AUD$23 Trillion of exposure for Australian banks is frighteningly large. Australian banks may claim that they are hedging (Insuring) however the size of their derivative positions dwarfs their total assets (AUD$3.1T table B1) so this argument doesn’t hold water. There is an article from The Weekend Australian, 18-19 October 2008, Business section, page 36 by Andrew Baggio, “who as a corporate lawyer structured complex derivatives, holds fears for the financial system.” He says:
“…when this [derivative] bomb explodes, the mushroom cloud will be of a magnitude that dwarfs the current crisis [GFC] and will change the world forever. This bomb is the over-the-counter [OTC] derivatives market.”
He goes on to describe the reckless way the deals happen. Look at table B2, Off Balance Sheet business, on the Reserve Bank web site to see how the bulk of Australian Banks’ exposure is Over-The-Counter (OTC) derivative exposure.
And the problem has been getting worse. The exposure grew by AUD$9 Trillion in the five years since 2008. So, during a global financial meltdown, Australian banks have increased their exposure to derivatives and other off balance sheet exposure by over 50%.
7.4 The US has similar problems
At the end of March 2013, US Banks had US$231 Trillion of derivative exposure. The big four US banks hold over 90% of these positions. Remember that the whole US economy only produces US$14T per year and the global economy is US$60T per year. Total US Bank shareholder equity is a mere $1.2T.
(To verify these figures go to the occ.gov web site, Office of the Comptroller of Currency and look at the ‘OCC’s Quarterly report on bank trading and derivative activities first quarter 2013’ table 1)
7.5 RISK AND RESILIENCE ISSUES
7.5.1 ‘Counter party failure’
(A counter party is the organisation on the other side of each transaction = the organisation betting the opposite way)
If there is counter party failure (this is where the bank, hedge fund etc at the other end of a deal goes broke) of even 1% of these positions, then the whole shareholder equity of Australian and US banks could be wiped out. If any loss was greater than 1% of exposure then bank deposits would be at risk. We’ll get to this shortly.
7.5.2 Bet the wrong way
A ‘significant bet’ that goes the wrong way, that results in a loss of 1% of the total exposure, will have the same result as a counter party failure of the same magnitude. There have been many precedents for this. Nick Leeson was an employee of Barings bank which was the oldest investment bank in the UK. In 1995 Nick was an unknown banker until he made bets that lost $1.4 billion and bankrupted Barings. In 2012 an employee of JP Morgan in London, known as The London Whale, made bets that lost JP Morgan $6 billion. Derivative exposure brought down AIG, the world’s largest insurer after losses on derivative bets exceeding $18 billion. Had it not been for the US government bailout, AIG would have imploded and some banks as counter parties would have imploded too.
7.5.3 How smart are our banks?
Markets are a mechanism for transferring money from people who “don’t know what is going on” to people “who do know what is going on.” My guess is that there are some much smarter people than in Australian banks. The people who were on the winning side of the bets above appear to be smarter than these bank and insurance people.
7.5.4 Risk is frighteningly big
As mentioned above, the scale of the exposure, and hence the risk, is enormous.
7.5.5 What happens if something goes wrong?
If a bet of 1%, or more, goes wrong, or, a counter party fails with the same loss, then there will be a large loss to share around that is greater than all of the shareholders’ equity in our banks. Banks are companies and without government intervention this loss would initially be worn by the shareholders first, and when all shareholder money is gone, unsecured depositors and unsecured creditors would wear the next losses. The reasoning behind these priorities for all companies is that shareholders take a larger risk and get rewarded when things are going well and should bear the brunt of losses when things go badly. The current bank exposure is so great that it is conceivable that all deposits could be at risk too.
7.5.6 Government guarantees the banks
In Australia ‘Government guarantees’ transfer risk from the private sector to the public sector. In reality the Australian government has intervened and is likely to continue to intervene in banking risk and loss sharing. It sounds noble of the government to guarantee bank deposits up to $250,000. The government has also gone guarantor for Australian Banks borrowing in the wholesale financial markets during the Global Financial crisis.
7.5.7 Size of the guarantees
7.5.7.1 Guarantee of bank deposits
“As at 28 February 2013, deposits eligible for coverage under the Financial Claims Scheme were estimated to be approximately $696.9 billion”
(Source: Australian budget paper No 1, 2013-14 Statement of contingent liabilities and assets, page 6 contingent liabilities – unquantifiable)
7.5.7.2 Banks wholesale funding guarantee
“As at 31 March 2013, total liabilities covered by the Guarantee Scheme were estimated at $55.2 billion”
(same 2013-2014 budget paper source)
7.5.7.3 Bank fees paid
“As at 28 February 2013, institutions participating in the Guarantee Scheme had paid $4.1 Billion since its inception.”
(source Same source: Risks to the budget overview)
I’m not aware of these fees being set aside and even if they were, $4 Billion may not go very far.
7.5.7.4 Combined exposure
In these two guarantees the Australian government is up for $752 billion if the Australian banks fail.
The government budget papers describe these guarantees as being only a liability:
“in the very unlikely event of a financial institution failure.” (same budget paper source)
Financial institution failure may not be as “very unlikely” as the government claims.
The Australian government also claims that:
“The Government continues to have robust and conservative strategies in place to reduce its potential exposure to these contingent liabilities.” (same budget paper - risks to the budget - overview)
I don’t believe them.
7.5.7.5 Extra $380 Billion Guarantee
Layered on top of the guarantees above is a $380 Billion dollar bank bailout facility from the Reserve Bank of Australia which was added in 2013. It is called the “Committed Liquidity Facility”. The Reserve Bank is a part of our Federal government.
7.5.7.6 Over $1 Trillion of exposure
This brings the risk for the Australian government to well over $1 Trillion should Australian banks fail.
7.5.8 The Ireland example
In Ireland the government went guarantor for the banks. Having to honour those guarantees has effectively destroyed the Irish economy. In Australia we need to look closely at the Irish situation to try and avoid the same outcome.
7.5.9 The Australian government’s financial position is terrible
The Australian government does not have reserves of cash to be able to write a cheque to pay out all of those guaranteed.
The government has negative equity. In other words it has liabilities that exceed its assets.
Thus, the government’s assets less liabilities is minus $280 billion and that is before taking into account guarantees and other contingent liabilities. If the government had to write a cheque for $1 Trillion then its net financial worth would become minus $1,280 billion and we would be in the same position as Greece.
On top of this, the government is running budget deficits that are making the negative equity worse.
Our government can’t pay such guarantees out of revenue either. The federal government hopes to collect $376 billion in total revenue from all sources in 2013-14 assuming that all goes well. If Australian banks go bankrupt then we know the government doesn’t have the cash to pay out those guarantees from revenue.
It appears that the government has made little or no provision for honouring these guarantees in the event of bank failure.
Banks aren’t the only people the government has guaranteed. The government has many more guarantees listed in their budget totaling many billions in extra exposure.
7.6 Risk and resilience summary
These banks have taken risks that could potentially blow up our entire economy.
As mentioned, if even 1% of these positions goes pear shaped, then potentially:
Bank shareholders could lose all value in their shares(stocks) unless the government injects money into them as the US government did for US banks in the Global Financial Crisis.
The government could become insolvent honouring the guarantees, or, it could print money to pay out the guarantees.
Australia could be plunged into a depression which would affect everyone.
If Australian banks did go bankrupt then bank share owners would have their resilience reduced accordingly.
The federal government would have its resilience reduced massively, perhaps terminally, by having to honour guarantees.
Depositors with over $250K in their account would potentially lose money. Even depositors with less than $250,000 in their accounts may find the government doesn’t have enough money to pay them.
[Chapter 7 continues with an explanation of how this happened plus recommendations for governments]
The next web sub page is Australian Banks derivative exposure which continues with this biggest risk to the Australian economy.